Financial Management

Unit 3
Cost of Capital
 Meaning of Cost of Capital
 The cost of capital of the company is the rate of
return it must earn in order to satisfy the expectation
of investors who provide long term funds to it.

 “Cost of Capital is the minimum required rate of

earnings or the cut off rate of capital expenditures” –
Solomon Ezra
 Importance of Cost of Capital
1. For a proper analysis of capital expenditure
decisions.
2. Several other decisions – like leasing, long term
financing and working capital management
3. Maximize the value of the firm.
 Cost of Equity
 “Maximum rate of return that the company must
earn on equity financed portion of its investments
in order to leave unchanged the market price of
the stock”.
 The cost of capital is a function of expected return
by its investors.
 Three methods:
1. Dividend Yield Method or Dividend/Price Ratio
Method
2. Dividend yield plus growth in dividend method
3. Earnings Yield Method
 Dividend Yield Method
 Here we assume that dividend remains constant.

 Ke = D/NP or D/MP;
where, Ke = Cost of equity capital
D = Expected dividend per share
NP= Net Proceedings per share
MP= Market Price Per share
 Illustration

A company issues 1000 equity shares of Rs 100 each at

a premium of 10%. The company has been paying 20%
dividend on equity share holders for the past 5 years and
expects to maintain the same in the future also.
Compute the cost of equity capital ?

Will it make any difference if the market price of equity

share is Rs 160?
Ans
Ke = D/NP = (20/110)*100
= 18.18 %

If market price of equity share is Rs 160,

Ke = D/MP = (20/160)*100
= 12.5 %
 Dividend Yield Plus Growth
 The dividends are expected to grow at a constant
rate

Ke = (DI/NP) + G or (DI/MP) + G

Where, Ke = Cost of equity capital
DI = Expected annual dividend per share
NP = Net proceedings per share
MP = Market price per share
G = Rate of growth in dividend
 Illustration 12, Management Accounting, Sharma &
Gupta
Ans – question 1
Ke = (D/NP) + G

= [10 / (100-5)] + 5%
= 0.1553
= 15.53%
 Ans – question 2
Ke = (D/MP) + G
= (10/150) + 5%
= 11.67 %
 For cost of existing equity share capital
Ke = (D1 / MP) + G
Problems
 Management Accounting, Sharma & Gupta, Page No
17. 12, Illustration 13
 Earnings Yield Method
 According to this method, the cost of equity capital is
the discount rate that equates the present value of
expected future earnings per share with the net
proceeds (or, current market price) of a share.

 Ke = EPS / NP or EPS/ MP,

Where, EPS = Earnings Per Share
NP = Net Proceeds
MP = Market Price Per Share
Earnings Yield Method
(cont…)
 This method can be applied in the following cases:

1. EPS is expected to remain constant.

2. Dividend payout ratio is 100 % or the retention
ratio is 0%.
3. When a firm is expected to earn an amount on new
equity share capital, which is equal to the current
rate of earnings.
4. The market price of share is influenced only by
EPS.
 Illustration
A firm is considering an expenditure of Rs 60 lakhs for
expanding its operations. The relevant information is as
follows:
Number of existing equity shares 10 lakhs
Market value of existing shares Rs 60
Net earnings 90 lakhs

Compute the cost of existing equity share capital and of

new equity capital assuming that new shares will be
issued at a price of Rs 52 per share and the cost of new
issue will be Rs 2 per share.
Ans: Cost of existing equity
capital
Ke = EPS / MP
EPS = PAT / No of shares outstanding
= 90,00,000 / 10,00,000
= Rs 9
MP = Rs 60
Ke = (9/60)*100
= 15 %
Ans: Cost of new equity
capital
Ke = EPS / NP
NP = 52 – 2
= 50
Ke = (9/50)*100
= 18%
Cost of Debt
Meaning
 The cost of debt is the rate of interest payable on
debt.
1. Before Tax Cost of Debt
2. After Tax Cost of Debt
 Before Tax Cost of Debt
Kdb = I/P
Where, Kdb = Before tax cost of debt
I = Interest
P = Principle

If the debt is raised at premium or discount, we should

consider NP in the place of P, ie net proceeds from issue
than the actual face value.

Kdb = I/NP ( where NP = Net Proceeds)

 After Tax Cost of Debt

Kda = [I/NP]*(1-t)
Where, Kda = After tax cost of debt
t = Rate of Tax

When debt is used as a source of finance, the firm

saves a considerable amount in payable of tax as
interest is allowed as a deductable expense in
computation of tax.
 Illustration

A company has 10% perpetual debt of Rs 100000. The tax

rate is 35%. Determine the cost of capital (before tax as
well as after tax) assuming the debt is issued at
1. At par
2. 10% discount
3. 10% premium
 Ans: Debt Issued at Par
Before Tax Cost of Debt
Kdb = I / P = 10000 / 100000 = 0.10 = 10%

After Tax Cost of Debt

Kda = [I/NP]*(1-t) = (10000/100000)* (1-0.35)
=0 .10*0.65 = .065
= 6.5%
 Ans: Debt Issued at Discount

Before Tax Cost

Kdb = I/NP = 10000/90000 = 0.1111 = 11.11%

After Tax Cost

Kda = [I/NP]*(1-t) = (10000/90000)*(1-0.35) = 0.1111*0.65
= 0.072215
= 7.22%
 Ans: Issued at Premium

Before Tax Cost

Kdb = I/NP = 10000/110000 = 0.09090 = 9.09%

After Tax Cost

Kda = [I/NP]*(1-t) = (10000/110000)*(1-0.35)

= 0.9090*0.65
= 0.0591
= 5.91%
Cost of Preference Shares
 Meaning
Preference share holders are having two rights over and
above equity share holders:
1. Right to get dividend before paying to equity share
holders, and
2. Right in getting the capital back while winding up the
business before the equity share holders are paid

Cost of preference share capital is the annual preference

share dividend divided by the net proceeds from the sale
of preference shares.
 Cost of Preference Share
Capital which is Perpetual
Kp = D/P
where, Kp = Cost of Preference Share Capital
D = Annual Preference Dividend
P = Preference Share Capital (Proceeds)
If the preference shares are issued at a premium or
discount or when cost of flotation are incurred to issue
preference shares, the nominal or par value of preference
share capital has to be adjusted to find out net proceeds.
In that case Kp = D/NP
 Illustration
A company issues 10000, 10% Preference Shares of Rs 100
each. The cost of issue is Rs 2 per share. Calculate cost
of preference share capital if these shares are issued:
1. At Par
2. At a premium of 10%
3. At a discount of 5%
 Ans: At Par

Kp = D/NP
D = Rs 100000
NP = 1000000 – 20000 = 980000
Kp = 100000/ 980000
= 0.1020
= 10.20%
 Ans: At a premium of 10%
Kp = D/NP
D = Rs 100000
NP = 1000000 + 100000 – 20000
= Rs 1080000
Kp = 100000/1080000
= 0.09259
= 9.26%
 Ans: At a discount of 5%
Kp = D / NP
D = Rs 100000
NP = 1000000 – 20000- 50000
= Rs 930000
Kp = 100000 / 930000
= 0.1075
= 10.75%
Cost of Redeemable Preference Shares
 Minimum Rate of Return
 Refers to minimum rate of return on a project a
manager or company is willing to accept before
starting a project, given its risk and opportunity cost
of forgoing the project.
 Weighted Average Cost of
Capital
 WACC is the average cost of the costs of various
sources of financing.
 Also known as composite cost of capital, over all cost
of capital or average cost of capital.

 Kw = ƩXW / ƩW
where, Kw = WACC
X = Cost of specific source of finance
W = Weight
 Illustration
A firm has the following capital structure and after tax costs for the
different sources of funds used:
Amount (Rs) Proportio After tax
n (%) cost (%)
Debt 15,00,000 25 5
Preference Shares 12,00,000 20 10
Equity Shares 18,00,000 30 12
Retained Earnings 15,00,000 25 11
60,00,000 100

Calculate Weighted Average Cost of Capital?

 Ans:
Source of Fund Proportio Cost% XW
n% (X)
(W)
Debt 25 5 1.25

Preference Shares 20 10 2
Equity Shares 30 12 3.6
Retained Earnings 25 11 2.75

WACC 9.6%
Problems of WACC
EBIT & EPS Analysis
 Financial Leverage
 The use of fixed- charges source of funds, such as
debt and preference share capital along with the
owners equity in the capital structure.

 Also called trading on equity.

 Financial Leverage affects the PAT and EPS.

 Measures of Financial
Leverage
1. The ratio of debt to total capital = D / V
2. The ratio of debt to equity = D / S
3. The ratio of Net Operating Income (EBIT) to
interest charges = EBIT / Interest
where, D = Value of Debt
V = Value of Total Capital
S = Value of Equity Capital
Problems
 Operating Leverage
 Operating Leverage affects a firms operating profit
(EBIT).
Problems
Reference
 www.investopedia.com
 Management Accounting, Sharma & Gupta, Kalyani
Publishers
 Financial Management, MY Khan & PK Jain, The
McGraw-Hill Companies.
 Financial Management, RK Sharma & Shashi K Gupta,
Kalyani Publications.
 Financial Management, Prasanna Chandra, Tata
McGraw Hill.
 Projects, Prasanna Chandra, Tata McGraw Hill.